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EC 170: Industrial Organization Professor George Norman Cummings Professor of Entrepreneurship and Business Economics Industrial Organization: Chapter 1 1 Introductory Remarks • Overview – study of firms and markets – strategic competition • Different forms of competition – prices – advertising – product differentiation Industrial Organization: Chapter 1 2 Introduction • How firms behave in markets • Whole range of business issues – – – – price of flowers which new products to introduce merger decisions methods for attacking or defending markets • Strategic view of how firms interact Industrial Organization: Chapter 1 3 • How should a firm price its product given the existence of rivals? • How does a firm decide which markets to enter? • Incredible richness of examples: – – – – – Microsoft/Netscape/Sun ADM (collusion) Toys R Us (exclusive dealing) American Airlines (predatory pricing) Merger wave • At the heart of all of this is strategic interaction Industrial Organization: Chapter 1 4 • Rely on the tools of game theory – focuses on strategy and interaction • Construct models: abstractions – well established tradition in all science • physics • engineering – are SUVs safe? – Do seat-belts/Volvos save lives? Industrial Organization: Chapter 1 5 The New Industrial Organization • The “New Industrial Organization” is something of a departure – theory in advance of policy – recognition of connection between market structure and firms’ behavior • Contrast pricing behavior of: – – – – grain farmers at first point of sale gas stations: Texaco, Mobil, Exxon computer manufacturers pharmaceuticals (proprietary vs. generics) Industrial Organization: Chapter 1 6 • Do not say much about the internal organization of firms – vertical organization is discussed – internal contracts are not Industrial Organization: Chapter 1 7 Efficiency and Market Performance • Contrast two polar cases – perfect competition – monopoly • What is efficiency? – no reallocation of the available resources makes one economic agent better off without making some other economic agent worse off – example: given an initial distribution of food aid will trade between recipients improve efficiency? Industrial Organization: Chapter 1 8 • Focus on profit maximizing behavior of firms • Take as given the market demand curve $/unit Equation: P = A - B.Q linear demand Maximum willingness to pay A Constant slope P1 Demand • Importance of: – time – short-run vs. long-run – willingness to pay Q1 A/B Quantity At price P1 a consumer will buy quantity Q1 Industrial Organization: Chapter 1 9 Perfect Competition • Firms and consumers are price-takers • Firm can sell as much as it likes at the ruling market price – do not need many firms – do need the idea that firms believe that their actions will not affect the market price • Therefore, marginal revenue equals price • To maximize profit a firm of any type must equate marginal revenue with marginal cost • So in perfect competition price equals marginal cost Industrial Organization: Chapter 1 10 MR = MC • • • • • • Profit is p(q) = R(q) - C(q) Profit maximization: dp/dq = 0 This implies dR(q)/dq - dC(q)/dq = 0 But dR(q)/dq = marginal revenue dC(q)/dq = marginal cost So profit maximization implies MR = MC Industrial Organization: Chapter 1 11 Perfect competition: an illustration With market price PC $/unit the firm maximizes profit by setting MR (= PC) = MC and producing quantity qc With market demand D2 • The supply curve moves to the right andmarket marketdemand supplyDS11 (a) The Firm (b)With The Industry • Price falls and market supply S1P1 equilibrium price is equilibrium price isis Q P1C $/unitprofits exist and quantity • Entry continues while and quantity is QCthat Now assume •Existing Long-run equilibrium is restored MC firms maximize demand atprofits price Pby supply curve S2 increasing C and S1 to increases D1 output AC to q1 D2 P1 S2 P1 Excess profits induce PC new firms to enter the market PC qc q1 Quantity Industrial Organization: Chapter 1 D2 QC Q1 Q´C Quantity 12 Perfect competition: additional points • Derivation of the short-run supply curve – this is the horizontal summation of the individual firms’ marginal cost curves $/unit Example 1: Three firms Firm 3 Firm 1 Firm 2 Firm 1: qMC = MC/4 = 4q +- 82 q1+q2+q3 Firm 2: qMC = MC/2 = 2q +- 84 Firm 3: qMC = MC/6 = 6q +- 84/3 Invert these 8 Aggregate: Q= q1+q2+q3 = 11MC/12 - 22/3 MC = 12Q/11 + 8 Industrial Organization: Chapter 1 Quantity 13 Example 2: Eighty firms $/unit Firm i Each firm: qMC = MC/4 = 4q +- 82 Invert these Aggregate: Q= 80q = 20MC - 160 8 MC = Q/20 + 8 Quantity • Definition of normal profit – not the same as zero profit – implies that a firm is making the market return on the assets employed in the business Industrial Organization: Chapter 1 14 Monopoly • The only firm in the market – market demand is the firm’s demand – output decisions affect market clearing price At price P1 consumers buy quantity Q1 $/unit P1 P2 At price P2 consumers buy quantity Q2 L Marginal revenue from a change in price is the Loss of revenue from the net addition to revenue reduction in price of units generated by the price currently being sold (L) change = G - L Gain in revenue from the sale of additional units (G) G Q1 Demand Q2 Industrial Organization: Chapter 1 Quantity 15 Monopoly (cont.) • Derivation of the monopolist’s marginal revenue Demand: P = A - B.Q $/unit Total Revenue: TR = P.Q = A.Q - B.Q2 A Marginal Revenue: MR = dTR/dQ MR = A - 2B.Q With linear demand the marginal revenue curve is also linear with the same price intercept but twice the slope of the demand curve Industrial Organization: Chapter 1 Demand MR Quantity 16 Monopoly and profit maximization • The monopolist maximizes profit by equating marginal revenue with marginal cost • This is a two-stage process Stage 1: Choose output where MR = MC $/unit This gives output QM Output by the monopolist isStage less 2: Identify the market clearing price MC than the perfectly This gives price PM competitive output AC QC MR is less than price Price is greater than MC: loss of efficiency Price is greater than average cost Demand PM Profit ACM MR QM QC Quantity Industrial Organization: Chapter 1 Positive economic profit Long-run equilibrium: no entry 17 Profit today versus profit tomorrow • Money today is not the same as money tomorrow – need way to convert tomorrow’s money into today’s – important since firms make decisions over time • is it better to make profit now or invest for future profit? • how should investment in durable assets be judged? – sacrificing profit today imposes a cost • is this cost justified? • Techniques from financial markets can be applied – the concept of discounting and present value Industrial Organization: Chapter 1 18 The concept of discounting • Take a simple example: – – – – – you have $1,000 this can be deposited in the bank at 5% per annum interest or it can be loaned to a start-up company for one year how much will the start-up have to contract to repay? $1,000 x (1 + 5/100) = $1,000 x 1.05 = $1,050 • More generally: – – – – you have a sum of money Y can generate an interest rate r per annum (in the example r = 0.05) so it will grow to Y(1 + r) in one year but then Y today trades for Y(1 + r) in one year’s time Industrial Organization: Chapter 1 19 • Put this another way: – – – – – – – assume an interest rate of 5% per annum the start-up contracts to pay me $1,050 in one year’s time how much do I have to pay for that contract today? Answer: $1,000 since this would grow to $1,050 in one year so in these circumstances $1,050 in one year is worth $1,000 today the current price of the contract is $1,050/1.05 = $1,000 the present value of $1,050 in one year’s time at 5% is $1,000 • More generally – the present value of Z in one year at interest rate r is Z/(1 + r) • The discount factor is defined as R = 1/(1 + r) • The present value of Z in one year is then R.Z Industrial Organization: Chapter 1 20 • What if the loan is for two years? – – – – – How much must start-up promise to repay in two years’ time? $1,000 grows to $1,050 in one year the $1,050 grows to $1,102.50 in a further year so the contract is for $1,102.50 note: $1,102.50 = $1,000 x 1.05 x 1.05 = $1,000 x 1.052 • More generally – a loan of Y for 2 years at interest rate r grows to Y(1 + r)2 = Y/R2 • Y today grows to Y/R2 in 2 years – a loan of Y for t years at interest rate r grows to Y(1 + r)t = Y/Rt • Y today grows to Y/Rt in t years • Put another way – the present value of Z received in 2 years’ time is R2Z – the present value of Z received in t years’ time is RtZ Industrial Organization: Chapter 1 21 • Now consider how to evaluate an investment project – generates Z1 net revenue at the end of year 1 – Z2 net revenue at the end of year 2 – Z3 net revenue at the end of year 3 and so on for T years • What are the net revenues worth today? – – – – – – Present value of Z1 is RZ1 Present value of Z2 is R2Z2 Present value of Z3 is R3Z3 ... Present value of ZT is RTZT so the present value of these revenue streams is: PV = RZ1 + R2Z2 + R3Z3 + … + RTZT Industrial Organization: Chapter 1 22 • Two special cases can be considered Case 1: The net revenues in each period are identical Z1 = Z2 = Z3 = … = ZT = Z Then the present value is: PV = Z (R - RT+1) (1 - R) Case 2: These net revenues are constant and perpetual Then the present value is: PV = Z R (1 - R) = Z/r Industrial Organization: Chapter 1 23 Present value and profit maximization • Present value is directly relevant to profit maximization • For a project to go ahead the rule is – the present value of future income must at least cover the present value of the expenses in establishing the project • The appropriate concept of profit is profit over the lifetime of the project • The application of present value techniques selects the appropriate investment projects that a firm should undertake to maximize its value Industrial Organization: Chapter 1 24 Efficiency and Surplus • Can we reallocate resources to make some individuals better off without making others worse off? • Need a measure of well-being – consumer surplus: difference between the maximum amount a consumer is willing to pay for a unit of a good and the amount actually paid for that unit – aggregate consumer surplus is the sum over all units consumed and all consumers – producer surplus: difference between the amount a producer receives from the sale of a unit and the amount that unit costs to produce – aggregate producer surplus is the sum over all units produced and all producers – total surplus = consumer surplus + producer surplus Industrial Organization: Chapter 1 25 Efficiency and surplus: illustration The demand curve measures the willingness to pay for each unit Consumer surplus is the area between the demand curve and the equilibrium price The supply curve measures the marginal cost of each unit Producer surplus is the area between the supply curve and the equilibrium price $/unit Competitive Supply PC Consumer surplus Equilibrium occurs where supply equals demand: price PC quantity QC Producer surplus Demand Aggregate surplus is the sum of consumer surplus and producer surplus The competitive equilibrium is efficient Industrial Organization: Chapter 1 QC Quantity 26 Illustration (cont.) Assume that a greater quantity QG is traded Price falls to PG $/unit The net effect is a reduction in total surplus Competitive Supply Producer surplus is now a positive part and a negative part PC Consumer surplus increases PG Part of this is a transfer from producers Part offsets the negative producer surplus Demand QC Industrial Organization: Chapter 1 QG Quantity 27 Deadweight loss of Monopoly Assume that the industry is monopolized The monopolist sets MR = MC to give output QM The market clearing price is PM Consumer surplus is given by this area And producer surplus is given by this area The monopolist produces less surplus than the competitive industry. There are mutually beneficial trades that do not take place: between QM and QC $/unit This is the deadweight loss of monopoly Competitive Supply PM PC Demand QM Industrial Organization: Chapter 1 QC MR Quantity 28 Deadweight loss of Monopoly (cont.) • Why can the monopolist not appropriate the deadweight loss? – Increasing output requires a reduction in price – this assumes that the same price is charged to everyone. • The monopolist creates surplus – some goes to consumers – some appears as profit • The monopolist bases her decisions purely on the surplus she gets, not on consumer surplus • The monopolist undersupplies relative to the competitive outcome • The primary problem: the monopolist is large relative to the market Industrial Organization: Chapter 1 29 A Non-Surplus Approach • • • • Take a simple example Monopolist owns two units of a valuable good There are 50,000 potential buyers Reservation prices: Number of Buyers Reservation Price First 200 $50,000 Next 40,000 $30,000 Last 9,800 $10,000 Both units will be sold at $50,000; no deadweight loss Why not? Monopolist is small relative to the market. Industrial Organization: Chapter 1 30 Example (cont.) • Monopolist has 200 units • Reservation prices: Number of Buyers Reservation Price First 100 $50,000 Next 40,000 $15,000 Last 9,900 $10,000 Now there is a loss of efficiency and so deadweight loss no matter what the monopolist does. Industrial Organization: Chapter 1 31 Anti-trust Policy: an overview • Developments in modern IO are sensitive to the policy context – Microsoft and ADM • highlight aspects of developments in policy/law and economic theory • Need for anti-trust policy recognized by Adam Smith (1776) – “The monopolists, by keeping the market constantly understocked, by never fully supplying the effectual demand, sell their commodities much above the natural price.” Industrial Organization: Chapter 1 32 – “People of the same trade seldom meet together, even for merriment or diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” • Sherman Act 1890 – Section 1: prohibits contracts, combinations and conspiracies “in restraint of trade” – Section 2: makes illegal any attempt to monopolize a market – contrast per se rule • collusive agreements/price fixing – rule of reason • “unreasonable” conduct Industrial Organization: Chapter 1 33 • Clayton Act (1914) – intended to prevent monopoly “in its incipiency” – makes illegal practices that “may substantially lessen competition or tend to create a monopoly” • Federal Trade Commission established in the same year • However, application affected by rule of reason – proof of intent – “the law does not make mere size an offence or the existence of unexerted power an offence - it does not compel competition nor require all that is possible.” Industrial Organization: Chapter 1 34 • Robinson-Patman (1936) – prohibits price discrimination that is intended to lessen competition – intended to prevent aggressive price discounting • The Alcoa case (1945) was also important – 90% market share – expanded capacity in advance of market expansion – inferred anti-trust violation from structure and conduct without overt evidence • 1980s and 1990s have seen a more relaxed attitude – emergence of large firms – importance of global competition Industrial Organization: Chapter 1 35 The New Industrial Organization • Dissatisfaction with the structure-conductperformance approach – collect profit data on firms in an industry – explain differences using information on size, organization, R&D, financial leverage etc. – but what is the direction of causation? • The “old” IO has limited treatment of product differentiation – representative firm, little strategic interaction • New IO: strategic decision-making (Hotelling) – scheduling of “blockbuster” and Disney movies Industrial Organization: Chapter 1 36